Risk management is a key component of corporate governance, and boards will look to their in house legal teams for advice on where the main legal risks arise.
In some areas this may be straightforward, but in relation to disputes, it can sometimes be difficult to predict where they will occur, as disputes are often the result of unique, random or bizarre events. For most corporates, large-scale litigation is outside the course of ‘business as usual’.
There is a limit on how far litigators can look at market trends to predict pressure points that increase litigation risk, but it is clear that we are living through an unprecedented era of political and economic instability when compared to recent history.
Unexpected political and global events, such as Covid-19, Russia’s invasion of Ukraine and, most recently, the UK government’s flirtation with unorthodox economics, often have unanticipated commercial impacts which give rise to disputes.
This all comes following a decade of unusual economic circumstances; incredibly low interest rates, plenty of liquidity and having had more and more capital hunting increasingly high risk yield. Many entities are not yet properly positioned for the change in market conditions and may find themselves exposed to unwanted risk that they can no longer pass off to counterparties.
Further, in the increasingly distressed global environment, parties are more willing to litigate, as commercial relationships may no longer be as important as enforcing rights and obtaining redress.
All these factors serve to make litigation more likely in the coming years. In this article we set out the key financial litigation trends we expect to see over the next few years. Companies that take early advice on how to mitigate their exposure in these areas could save significant time and costs down the line.
Shadow banking
The shadow banking system consists of unregulated lenders, brokers and other financial intermediaries such as hedge funds placing financial products to facilitate the creation of credit and liquidity. However, unregulated entities dealing in highly leveraged structures often without being capitalised like regulated banks leaves customers and counterparties more exposed.
A good example of a quiet corner of the market suddenly developing a systemic issue after a sudden change in market conditions driven by external factors is the recent market crisis experienced by some pension funds running leveraged liability driven investment (‘LDI’) strategies.
The rise in gilt yields following the then-chancellor’s ‘fiscal event’ generated large margin calls that led to a self-sustaining selling cycle, in turn drove up collateral requirements: a ‘doom loop’.
The Bank of England stepped in by buying up gilts to lower yields and a major crisis seems to have been averted, but it is likely that some funds may have suffered significant losses in part caused by forced sales of longer-term assets at an undervalue to replenish liquidity and collateral buffers.
Whether this particular episode gives rise to litigation will likely depend on what (if any) losses can be identified once the dust settles.
However, it serves to illustrate that leveraged structures coupled with a sudden change in market conditions have an outsize impact which parties may not be immediately prepared for or able to deal with.
There is a large amount of leverage outside the purview of banks (and their regulators) and it is far from certain that the Bank of England would be willing to intervene in other market sectors, particularly those which have less impact on the stability of the market as a whole.
We anticipate that similar issues could arise in the OTC derivatives and in the private credit markets, which may then lead to litigation as parties seek to recover losses and enforce contracts.
Securities litigation
UK investors have become much more active and willing to seek redress where they have suffered losses arising from omissions or misstatements in a company’s published information.
This has resulted in a number of claims brought before the English courts against financial institutions and businesses by their shareholders on the basis of section 90 and Schedule 10A of FSMA.
The availability of litigation funding, claims management technology and insurance for these types of claims means that securities actions can be structured to minimise the risk to claimants in return for contingent fees being paid to stakeholders on success, which is a further attraction to some clients.
Some of the biggest securities claims have been born out of institutions facing existential crises and seeking to raise capital in a hurry, resulting in corners being cut. If market conditions worsen dramatically then we expect to see more issues of this nature where companies weigh up the future legal risk of securities claims against the more immediate risk of an impending cash crunch and prioritise survival.
In any event, we expect to see an increase in securities actions over the next few years as the sector continues to develop.
Fraud
In our experience large scale fraud falls into two broad categories: fraudulent schemes created and driven by sophisticated dishonest operators and corporate fraud where in order to achieve targets or conceal an unexpected capital hole, certain individuals with a previously clean track record engage in dishonest behaviour, be it over-egging the value of holdings or lying about cash balances.
The latter takes time to come to light and, by the time it does, the results can be explosive and catastrophic for the business.
One would expect either internal or external auditors to identify fraud at an early stage but, as the recent issues with Wirecard and NMC Health have shown, this assumption cannot be relied on and indeed there may be further claims against auditors in this regard in the coming years.
Systems and controls have vastly improved in most financial businesses over the last fifteen years but human ingenuity and error means that such controls can still be circumvented giving rise to litigation and regulatory risk.
The speed of technological change and customer behaviour, coupled with changes to working practices, poses a further challenge for internal control environments and the sizeable fines the SEC recently imposed on a number of financial institutions shows the difficulties in properly policing this area.
It seems inevitable that as the tide continues to go out more issues with a fraud element will come to light, with litigators involved both in investigations and seeking to recover losses.
International sanctions
The international response to Russia’s invasion of Ukraine has brought into sharp focus the impact of sanctions on international finance and business.
The UK, US and EU package of sanctions has been unprecedented. UK financial institutions have been scrambling to comply by ceasing operations and severing financial arrangements with Russian entities.
This will inevitably give rise to disputes, with potential claimants looking to recoup losses from non-sanctioned parties outside Russia where they have a better chance of recovering funds. For example, a financial institution may decide to cancel lending facilities in breach of contract as the risk to the lender of being penalised by sanctions authorities is greater than that of breaching their contract. Counterparties may seek to bring claims against banks outside Russia that have an interest in the transaction. We also expect to see a rise in
claims against insurers as they seek to avoid cover.
Outside Russia, in recent years there have been a number of disputes arising from investment in the UK and Europe by investors from politically unstable jurisdictions where sanctions are now in place (such as Libya and Iran).
As this instability sadly shows no signs of disappearing, and with political tensions with important global players, including China, increasing, we expect disputes driven by geopolitical tensions to continue.
The end of LIBOR
LIBOR has been a hotly debated (and litigated) issue following the 2008 financial crisis.
Claimants have had limited success when bringing misrepresentation claims based on the manipulation of LIBOR, as it is difficult for claimants to establish reliance on the misrepresentation.
However, a new stream of LIBOR-related claims is possible as a result of the announcement by the Financial Conduct Authority (the FCA) in 2017 that banks would not be asked to contribute to the rate after 2021. On 31 December 2021, most LIBOR benchmark settings ceased, with the remaining to follow. LIBOR is being replaced with Risk-Free Rates (RFRs).
Despite policymakers’ attempts to reduce situations where disputes may arise, there will inevitably be situations where parties will not be able to agree a solution. Though the legal principles surrounding interpreting contracts where circumstances change dramatically are well established, these have not yet been applied to the LIBOR situation, so we expect to see parties and regulators resorting to the courts for guidance.
This is very much uncharted territory that could potentially become a highly litigious area if the courts are required to establish principles for determining the substitute rate.
Environmental, social and governance
The popular focus on climate change issues is another area that is likely to come under scrutiny as part of the corporate reporting of ESG credentials.
UK companies are required to publish information relating to a broad spectrum of ESG issues, which range from climate footprint to human rights.
The Financial Conduct Authority (FCA) has introduced ‘comply or explain’ regulations requiring listing companies to comply with the guidance on climate-related disclosures published by the UK Joint Government Regulator Task Force on Climate-related Financial Disclosures, or explain why they have not done so.
Investors are increasingly concerned that their investments are ethical, and many funds have strict investment criteria for ethical investments.
Therefore, where it transpires that a company has published untrue and misleading statements regarding its ESG record, investors may be able to establish reliance under Schedule 10A of FSMA if it can show that the true credentials would not have met the investment criteria, giving rise to a securities action.
In the US, there have been nearly 40 securities litigation claims alleging inaccurate ESG disclosures and this trend may transfer across the Atlantic.
Data
Large scale data breaches are an increased risk for corporates, either caused by in-house error or by malicious hackers.
Whilst IT security continues to improve, we anticipate the hacking attacks will continue to evolve and become more sophisticated and this will continue to be a key risk area.
We expect to see more consumer claims brought regarding data breaches in the coming years.
Crypto-assets
Litigation involving crypto-assets continues to grow, and we expect more high-profile cases will soon become the norm, particularly as ‘traditional finance’ continues to make inroads into the sector.
Currently, most crypto-investments are not specified investments under the FSMA, so customers do not benefit from statutory or regulatory protection which has led to individuals and entities seeking relief from the court, often in the form of world-wide freezing orders.
There is obviously a wide-range of views about the long term viability of bitcoin and other crypto-assets but as long as there is demand for those assets and people ascribe a value to them then we expect the nature of the existing ecosystem to inevitably give rise to litigation.
Conclusion
We believe that the next few years will see a more diverse range of disputes than what we saw in the wake of the 2008 financial crisis.
Then, litigation was focused around a number of key causes of action available to customers, investors and counterparties arising from a pattern of behaviour of financial institutions across the board.
In the current climate, financial institutions face litigation risk on a number of different fronts and not of their own doing: political, technological, and economic.
There will also be the more run-of-the-mill litigation arising from a more stressed credit environment and breaches of contract by counterparties.
For the judiciary and litigators, it will be fascinating in unpredictable ways but, for businesses, it may be a painful and difficult few years